Chapter 5



Chapter 6

Accounting for Merchandising Businesses

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OPENING COMMENTS

Chapter 6 introduces the merchandising form of business. It opens by contrasting the income statements of service and merchandising businesses. The chapter also summarizes the essential differences between the periodic and perpetual inventory systems.

After a brief description of the periodic inventory system, the chapter focuses solely on the perpetual system. The text illustrates how to record transactions related to the sale and purchase of merchandise under the perpetual inventory system. It also presents a chart of accounts, an income statement, and an overview of the accounting cycle for a merchandiser using a perpetual inventory system.

The 20th edition of ACCOUNTING focuses on the perpetual inventory method, since computerized accounting and inventory systems have made it feasible for even small merchandisers to track each purchase and sale of inventory. In a computerized accounting system, the need for a work sheet is virtually eliminated, and closing entries are performed automatically. Therefore, discussion of these topics is covered in Appendix 2 at the end of this chapter. You may choose to omit coverage of this appendix. This action will not hinder your students’ work in future chapters. Appendix 1 illustrates recording merchandising transactions using a manual accounting system with special journals and a computerized accounting system using QuickBooks.

The mechanics of the periodic inventory system for merchandisers are covered in Appendix D at the end of the text.

After studying the chapter, your students should be able to:

1. Distinguish the activities of a service business from those of a merchandising business.

2. Journalize the entries for merchandise transactions, including:

a. Merchandise purchases

b. Merchandise sales

c. Merchandise transportation costs

d. Transactions for both the buyer and the seller.

3. Prepare a chart of accounts for a merchandising business.

4. Prepare an income statement for a merchandising business.

5. Describe the accounting cycle for a merchandising business.

6. Compute the ratio of net sales to assets as a measure of how effectively a business is using its

assets.

OBJECTIVE 1 — Distinguish the activities of a service business from those of a merchandising business.

KEY TERMS:

Cost of Merchandise Sold

Gross Profit

Merchandise Inventory

SUGGESTED APPROACH

The goal of Objective 1 is to introduce the student to the basic skeleton of the income statement for the merchandiser.

Sales

- Cost of Merchandise Sold

Gross Profit

- Operating Expenses

Net Income

To demonstrate the need for this new format, ask your students the following question: What is the largest expense incurred by a retail store, such as K Mart or The Limited? Answer: the cost of the merchandise that is sold to the customer.

Because this cost is the retailer's major expense, it is shown separately from the operating expenses when preparing the income statement. The cost of merchandise sold is deducted from sales to get the subtotal gross profit. This amount is the profit left after "paying for" the merchandise that was sold to the customer. It must be used to "pay" the retailer's operating expenses, such as salaries, rent, utilities, and advertising.

Objective 1 also introduces Merchandise Inventory, explaining that this account is reported as a current asset on the balance sheet.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-1

Exercise 6-2

OBJECTIVE 2a — Journalize the entries for merchandise purchases.

KEY TERMS:

Debit Memorandum Physical Inventory

Invoice Purchases Discounts

Periodic Inventory System Purchases Returns and Allowances

Perpetual Inventory System

SUGGESTED APPROACH

This objective opens with a brief comparison of the perpetual and periodic inventory systems. Transparencies 6-1 through 6-3 contrast the two inventory systems, show the costs and benefits of a perpetual inventory system, and offer insight on how businesses choose an inventory system. To illustrate the essence of a perpetual inventory system, relate it to a checkbook. Maintaining a checkbook register for a bank account is a type of perpetual inventory system. By tracking increases (deposits) and decreases (withdrawals or checks written) in the checkbook register, you can keep a running balance of your cash.

After reviewing these inventory systems, the text covers journal entries for purchases under the perpetual inventory system. The following demonstration problem will introduce these new entries to your class.

DEMONSTRATION PROBLEM — Entries for Merchandise Purchases

Purchases of merchandise for resale to a customer are recorded in the merchandise inventory account. Point out that this account is an asset. Therefore, it is debited whenever inventory is increased and credited whenever inventory is decreased.

Transparency 6-4 lists purchase-related transactions for S & V Office Supply Company. One method to present this material is to give the students examples of the entries to record purchases of inventory items in lecture format. Another is allow students to decipher the entries on their own. Try reading the first transaction to your students and ask them to journalize it in their notes. After giving them a minute to work, show them the correct journal entry. Proceed with the other transactions listed on the transparency. The correct journal entries are listed on Transparency 6-5.

The transactions on Transparency 6-4 do include references to credit terms (for example, 2/10, n/30). You may want to explain these credit terms before beginning this exercise. Also note that all merchandise purchases are recorded at invoice price; discounts are shown as a reduction to the cost recorded for the inventory only if they are taken. The amount of the discount is credited to the merchandise inventory account at the time of payment.

LECTURE AIDS — Discounts

For many students, a 2% discount doesn’t sound very impressive. They may need a little help understanding the true financial impact of taking discounts on purchases. The following questions will stress the savings of taking discounts:

1. What is the net savings from borrowing at a 12% interest rate in order to take the discount on a $10,000 purchase, terms 1/10, n/30? Answer: $34 ($100 - {$9,900 x 20/360 x 12%}).

2. What is the interest rate earned on taking a discount with terms 3/15, n/60? Answer: 24% (3% x 360/45).

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-3

Exercise 6-5

Exercise 6-6

Exercise 6-8

OBJECTIVE 2b — Journalize the entries for merchandise sales.

KEY TERMS:

Credit Memorandum Sales Returns and Allowances

Sales Discounts Trade Discounts

SUGGESTED APPROACH

This objective covers the entries to record sales in a perpetual inventory system. Begin by stressing that selling merchandise to a customer requires two entries—one to record the sales revenue and another to remove the item sold from merchandise inventory. Again, these entries can be presented in lecture format or you can introduce the students to the new accounts used to record sales and allow them to discover the entries on their own.

LECTURE AIDS — Entries To Record Merchandise Sales

Transparencies 6-6 and 6-7 present a matrix that explains the new accounts related to sales. Review these transparencies with your class.

Transparencies 6-8 and 6-9 list several sales-related transactions for S & V Office Supply Company. Read the first transaction to your students and ask them to journalize it in their notes. After giving them a minute to work, show them the correct journal entry. Proceed with the other transactions listed on the transparency. The correct journal entries are listed on Transparencies 6-10 and 6-11.

WRITING EXERCISE — Recording Merchandise Sales

To emphasize some of the operational considerations in recording sales, ask your students to write answers to one or more of the following questions (Transparency 6-12).

1. Why would a retailer offer customers sales discounts?

2. How is using a separate account for sales returns and allowances useful to management?

3. If you owned a merchandising business, how would you decide which credit cards, if any, to accept?

4. Which of the following credit terms would be more generous to your customers: n/30 or n/eom?

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-9 Exercise 6-12

Exercise 6-10 Exercise 6-14

Exercise 6-11 Exercise 6-15

OBJECTIVE 2c — Journalize the entries for merchandise transportation costs.

KEY TERMS:

FOB Destination

FOB Shipping Point

SUGGESTED APPROACH

FOB (free on board) terms identify (1) when legal title to goods passes from seller to buyer and (2) who is responsible for paying transportation costs. Transparency 6-13 lists the operational implications of FOB terms.

Notice that Transparency 6-13 points out that the buyer bears the risk of loss during transportation when merchandise is shipped FOB Shipping Point. Therefore, the buyer should make sure that the merchandise is insured against loss during shipment.

A couple of points related to shipping terms usually need special emphasis. First, when merchandise is shipped FOB shipping point, the seller frequently prepays the transportation costs and adds this amount to the buyer’s invoice. Second, remind students that transportation costs are not eligible for early payment discounts. Those discounts apply only to the cost of the merchandise purchased. To test their understanding of these concepts, ask them to compute the cash to be paid in the following problem (Transparency 6-14.)

Logan Appliances purchased $8,000 of merchandise, 2/10, n/30, FOB shipping point. The seller prepaid the shipping charges of $200. If Logan pays for this merchandise within the discount period, how much should Logan remit to the seller? (Answer: $8,040.)

DEMONSTRATION PROBLEM — Transportation Costs on Purchases

Ask your students to record the transactions related to the purchase of merchandise and transportation costs on Transparency 6-15. The correct entries are listed on Transparency 6-16.

LECTURE AIDS — Transportation Costs on Sales

If merchandise is sold FOB destination, the seller is responsible for paying the shipping cost. The cost is debited to Transportation Out. For example, assume goods costing $100 are sold to a customer on account for $250, terms FOB Destination. The freight cost paid to have these goods delivered is $25. The following entries are needed to record this sale and the transportation costs:

Accounts Receivable………… 250

Sales…………………. 250

Cost of Merchandise Sold…… 100

Merchandise Inventory 100

Transportation Out………….. 25

Cash…………………. 25

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-4 Problem 6-1A Problem 6-1B

Exercise 6-7 Problem 6-2A Problem 6-2B

Exercise 6-13 Problem 6-3A Problem 6-3B

Exercise 6-18

OBJECTIVE 2d — Journalize the entries for merchandise transactions for both the buyer and the seller.

SUGGESTED APPROACH

Just as one person's pay increase is another person's price increase, one person's sale is another person's purchase. This learning objective illustrates a series of transactions from both the seller's and buyer's points of view. In reality, this simply reinforces material already covered in the earlier sections of Objective 2.

If you wish to give your students additional practice, you could ask them to work textbook Problem 6-4A or 6-4B in class or assign one of these problems as homework.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-16 Problem 6-4A Problem 6-4B

Exercise 6-17

OBJECTIVE 3 — Prepare a chart of accounts for a merchandising business.

SUGGESTED APPROACH

In discussing the chart of accounts for a merchandising firm, the text uses a 3-digit account number. This reflects the growing number of accounts required by the increased complexity of a merchandiser's accounting transactions.

Under the 3-digit chart of accounts, the first digit represents the account classification (1 for assets, 2 for liabilities, etc.). The second represents the subclassification (11 for current assets and 21 for current liabilities). The third digit identifies the specific account.

TEACHING SUGGESTION — Chart of Accounts

After explaining the text's system, it is interesting to point out the variety in charts of accounts and their numbering systems by providing some real-world examples. Ask students to bring in copies of charts of accounts for merchandising businesses. Students may have access to charts of accounts through their job or the job of a relative. As an alternative, you may want to describe the chart of accounts for a local company you are familiar with.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-19

OBJECTIVE 4 — Prepare an income statement for a merchandising business.

KEY TERMS:

Administrative Expenses Multiple-Step Income Statement

Cost of Merchandise Sold Other Expense

Gross Profit Other Income

Income from Operations Selling Expenses

Loss from Operations Single-Step Income Statement

SUGGESTED APPROACH

Chapter 6 introduces the multiple-step income statement. This income statement format contains various sections, subsections, and subtotals, which increases the length and complexity of the income statement. Point out that the benefit of this more detailed format is greater flexibility in analyzing a company’s performance. For example, the gross profit percentage (gross profit divided by net sales) is used to analyze the mark-up above cost charged by retailers.

The trap that many students fall into is blindly attempting to memorize the multiple-step income statement line by line. Instead, they need to approach it as a series of pieces (sections) that must be fit together to provide a total picture of a company—similar to fitting together pieces of a jigsaw puzzle.

Transparency 6-17 shows the individual sections of the multiple-step income statement and how they interrelate. Review this transparency with the class, explaining each section and its placement in the statement.

GROUP LEARNING ACTIVITY — Prepare Financial Statements for a Merchandiser

Transparency 6-18 lists an adjusted trial balance for Gem City Music. Divide students into small groups and ask them to prepare an income statement for this retailer. If time permits, you may also want them to prepare a statement of owner's equity and balance sheet as a review of those financial statements. A completed income statement is shown on Transparency 6-19.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-20 Exercise 6-23

Exercise 6-21 Exercise 6-24

Exercise 6-22 Exercise 6-25

OBJECTIVE 5 — Describe the accounting cycle for a merchandising business.

KEY TERMS:

Account Form of Balance Sheet

Inventory Shrinkage

Report Form of Balance Sheet

SUGGESTED APPROACH

Objective 6 contrasts the account form of balance sheet (assets on the left-hand side and liabilities and owner’s equity on the right-hand side) with the report form (assets at the top of the page with liabilities and owner’s equity at the bottom). The report form is illustrated in Exhibit 10 on page 246. An account form of balance sheet can be found back in Chapter 4 on page 138C or page 154. A quick reference to these illustrations should be sufficient to explain these two balance sheet formats. You may want to check your students’ comprehension of these formats by asking them to identify whether the balance sheet for Hershey Foods Corporation in Appendix G is in report form or account form.

Transparency 6-20 presents the year-end procedures used by a merchandising company in a manual accounting system. Emphasize that merchandising companies use the same basic year-end procedures as service businesses.

Accounting work at year-end can be greatly reduced by implementing a computerized accounting system. In a computerized system, it is not necessary to prepare a work sheet—a good software package can prepare financial statements immediately after adjusting entries have been input. Computerized accounting packages also prepare closing entries automatically. Since personal computers have made it financially feasible for even small businesses to computerize their accounting systems, work sheets and closing entries for merchandisers are covered in the appendix to this chapter.

However, the accountant still must input adjusting entries, even in a computerized accounting system. This objective introduces the adjusting entry for inventory shrinkage. Remind students that merchandisers also record any of the adjusting entries introduced in Chapter 3 which are applicable (for example, supplies used, insurance expired, wages owed to employees, fees earned, etc.).

LECTURE AIDS — Adjusting Entry for Inventory Shrinkage

Unfortunately, inventory shrinkage is considered a normal cost of operations for a retailer. Theft of inventory (shoplifting), damaged inventory, and mistakes in recording inventory can never be totally eliminated. Therefore, the inventory account must be adjusted prior to preparing financial statements. Any shrinkage is recorded as an expense.

For example, assume a company’s perpetual inventory records show that there should be $89,500 of inventory on hand. (Emphasize that the perpetual records show what should be in inventory based on merchandise purchased and sold during the year.) However, a physical inventory count reveals that only $87,000 is actually on hand at year end. Ask your students to determine the amount of shrinkage. (Answer: $2,500.)

This shrinkage is recorded as following:

Cost of Merchandise Sold………. 2,500

Merchandise Inventory….. 2,500

You may want to point out that if the amount of shrinkage is unusually large, it is better to record it in a separate account, such as Loss From Merchandise Inventory Shrinkage. Also stress that all companies must do a physical inventory count at least once per year to verify the information in the perpetual inventory records.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-26 Problem 6-5A Problem 6-5B

Exercise 6-27 Problem 6-6A Problem 6-6B

OBJECTIVE 6 — Compute the ratio of net sales to assets as a measure of how effectively a business is using its assets.

SUGGESTED APPROACH

The ratio of net sales to assets is used to measure how efficiently a business is using its assets to generate sales. The formula for this ratio is:

Net Sales

Ratio of Net Sales to Assets = Average Total Assets

It is important to explain the meaning of this ratio and illustrate its calculation.

LECTURE AIDS — Ratio of Net Sales to Assets

The following examples can be used to help students interpret the ratio of net sales to assets:

If a business has $1,000 in assets and $2,000 of sales, the ratio of net sales to assets is 2.0 ($2,000/$1,000). Every dollar invested in assets generates two dollars of sales.

If a business with a ratio of net sales to assets of 1.5 has $1,000 in assets, what amount of sales revenue did the business generate? (Answer: $1,500.)

The actual formula for computing the ratio of net sales to assets uses “Average Total Assets.” Transparency 6-21 can be used to explain this calculation. A business’ sales are earned across an entire year. As a result, annual sales needs to be compared to the average amount of assets used during the year. While it would be better to average total assets at the end of each month, as a short-cut, the beginning and end of year amounts can be averaged.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-28 Exercise 6-29

APPENDIX 1 — Accounting Systems for Merchandisers

SUGGESTED APPROACH

This objective discusses the processing of accounting entries for merchandisers under manual and computerized accounting systems. The manual system looks at changes that would be needed to adapt the special journals, introduced in Chapter 5, for a merchandiser. The computerized system illustrates recording inventory purchases and sales using QuickBooks.

LECTURE AIDS — Manual Accounting System

Make an overhead transparency of a revenue journal form from the working papers for Chapter 5. Ask your students to sketch the form that would be used by a merchandiser to record sales to customers on account. After allowing a few minutes for students to put their ideas on paper, refer them to the Sales Journal in Exhibit 11, page 248. You may want to poll your students to see how many added a column to record the cost of merchandise sold.

Point out the following differences in the remaining special journals:

Exhibit 12 - Purchases Journal includes a Merchandise Inventory Dr. column.

Exhibit 13 - Cash Receipts Journal has two modifications to accommodate cash sales: (1) includes a Sales Cr. column, (2) includes a Cost of Merchandise Sold Dr./Merchandise Inventory Cr. column to record the cost of inventory sold to cash customers. The journal also has a Sales Discounts Dr. column to record discounts taken by customers paying within the discount period.

Exhibit 14 - Cash Payments Journal includes a Merchandise Inventory Cr. column to record discounts taken on inventory purchases.

GROUP LEARNING ACTIVITY - Computerized Accounting Systems

The text illustrates the screens used to input inventory purchases and sales using QuickBooks. These illustrations are found on pages 250 and 251 (Exhibits 16 and 17). Exhibit 15, found on page 250, shows the information needed to initially set up inventory items.

Ask your students to review Exhibits 16 and 17 and identify the accounting entries QuickBooks creates to record these transactions. The solution is found on Transparency 6-22.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-30

APPENDIX 2 — Work Sheet and Adjusting and Closing Entries for a Merchandising Business

SUGGESTED APPROACH

So that your students understand (and appreciate) the work performed by a computer at year-end, this appendix covers the manual steps in preparing financial statements and closing the books of a merchandiser. This material can be covered quite effectively as a group learning activity, since it is essentially a review of processes introduced in Chapters 3 and 4.

GROUP LEARNING ACTIVITY — Preparing the Work Sheet of a Merchandiser

Handout 6-1 is a sample work sheet that may be copied and distributed to your students. Divide the class into small groups and ask them to complete the Adjustments column of the work sheet. They will need to record the following adjustments:

1. A physical inventory count revealed that only $9,600 of merchandise is on hand.

2. Salaries owed to office employees equal $550; salaries owed to sales employees equal $700.

3. $2,800 in depreciation should be recorded on the office equipment.

After your students have prepared the adjusting entries, they should be instructed to complete the remaining columns. To save class time, the balances for all accounts not affected by adjusting entries have been entered into the Adjusted Trial Balance and Financial Statement columns. Your students will need to fill in balances only for accounts that were adjusted. Transparency 6-23 shows the completed work sheet.

Remind students that the adjustments recorded on the work sheet must be journalized and posted to make them part of a company's accounting records. It will probably suffice to simply remind students of this fact. If you wish to give your students additional practice in this area, you could ask them to record the adjustments from Handout 6-1 in journal entry format. The adjusting journal entries can be taken directly from the Adjustments column of the work sheet.

GROUP LEARNING ACTIVITY — Closing Entries for a Merchandiser

The process of closing entries has not changed from Chapter 4; there are simply more accounts to close. In a perpetual inventory system, the sales discounts, sales returns and allowances, and cost of merchandise sold accounts are closed to Income Summary, along with the other debit balance accounts shown in the Income Statement column of the work sheet.

Transparency 6-24 reviews the basics of the closing process. Remind students that closing entries can be taken directly from the Income Statement columns of the work sheet. Also stress that the balance of the Income Summary account after the first two closing entries must equal the net income or net loss for the period. After a brief review of these concepts, ask your students to

prepare closing entries for Gem City Music, using the work sheet on Handout 6-1. These closing entries are displayed on Transparency 6-25.

EXERCISES & PROBLEMS FOR REINFORCEMENT:

Exercise 6-31 Problem 6-7A Problem 6-7B

Handout 6-1

Gem City Music

Work Sheet

For the Year Ended December 31, 20—

| | | | | | ADJUSTED | | | | |

| ACCOUNT TITLE | TRIAL BALANCE | ADJUSTMENTS | TRIAL BALANCE | INCOME STATEMENT | BALANCE SHEET |

| | DEBIT | CREDIT | DEBIT | CREDIT | DEBIT | CREDIT | DEBIT | CREDIT | DEBIT | CREDIT |

| | | | | | | | | | | |

|Cash | 11,000 | | | | 11,000 | | | | 11,000 | |

|Accounts Receivable | 15,800 | | | | 15,800 | | | | 15,800 | |

|Merchandise Inventory | 10,400 | | | | | | | | | |

|Office Equipment | 23,000 | | | | 23,000 | | | | 23,000 | |

|Accumulated Depreciation | | | | | | | | | | |

| —Office Equipment | | 6,400 | | | | | | | | |

|Accounts Payable | | 16,000 | | | | 16,000 | | | | 16,000 |

|Salaries Payable | | | | | | | | | | |

|M. Marx, Capital | | 11,500 | | | | 11,500 | | | | 11,500 |

|M. Marx, Drawing | 12,800 | | | | 12,800 | | | | 12,800 | |

|Sales | | 189,300 | | | | 189,300 | | 189,300 | | |

|Sales Returns and | | | | | | | | | | |

| Allowances | 1,700 | | | | 1,700 | | 1,700 | | | |

|Sales Discounts | 500 | | | | 500 | | 500 | | | |

|Cost of Merchandise Sold | 99,200 | | | | | | | | | |

|Rent Expense | 7,800 | | | | 7,800 | | 7,800 | | | |

|Sales Salaries Expense | 17,000 | | | | | | | | | |

|Office Salaries Expense | 22,000 | | | | | | | | | |

|Depreciation Expense | | | | | | | | | | |

| —Office Equipment | | | | | | | | | | |

|Interest Expense | 2,000 | | | | 2,000 | | 2,000 | | | |

| | 223,200 | 223,200 | | | | | | | | |

| | | | | | | | | | | |

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